Month: September 2014

Tax Efficient Asset Allocation

Taxes are painful for everyone. Most high net worth investors are only too happy to wave goodbye to tax time every year. Gathering all of the investment income slips can be a chore, although the real pain lies in preparing the return and paying the taxes.

Complicating this ordeal is the fact that many affluent investors work with more than one investment firm and multiple investment advisors. This lends itself to a piecemeal approach to investment management that often results in needless tax inefficiencies and higher tax bills.

Investors should pay particular attention to asset allocation which is the process of placing particular investments in either taxable or tax advantaged accounts. Having the same asset allocation in every type of account is not efficient. By putting an asset into the type of account that will give it the best tax treatment, investors might be able to realize 20 to 50 basis points of additional return each year. That may not sound like much, but after 30 years or more, the tax savings will add up and enhance final retirement assets by as much as 30%, thanks to the power of compounding.

Start by putting investments subject to the highest marginal tax rate in tax advantaged accounts. Currently, tax advantaged accounts should be populated first with bonds. If a client has additional room in tax advantaged vehicles it should be used for high turnover, active equities.

To add insult to injury where bonds are concerned is the fact that most bonds trading today were issued long ago when bond coupons of 4% to 8% were quite common. In today’s low interest rate environment, these bonds trade at substantial premiums to their eventual maturity value.


Unfortunately, it is the hefty coupon yield that is taxed at the full marginal rate, while the amortized premium is only allowed as capital loss on maturity. This mismatched tax treatment tremendously magnifies the overall tax drag of bond portfolios held in taxable accounts.

Taxable accounts, on the other hand, should hold stocks because the capital gains and dividend tax rates applied to them will be substantially lower than most investors’ marginal tax rate.

There is no point in housing investments that could be subject to this lower rate in a deferred account, only to pay higher tax rates at the time of withdrawal. Although capital gains and dividends received within a registered account can be reinvested on a tax deferred basis, when an affluent investor’s RRSP is eventually converted to a RRIF, the mandatory withdrawals are fully taxed as income. As well, by holding stocks in registered accounts, there is no possibility of tax loss harvesting to offset gains elsewhere.

Decisions about asset location can also be vital during a client’s withdrawal phase.

Investors should attempt to refrain from withdrawing from their RRSPs before clients reach age 72, when they must make mandatory withdrawals from RRIF accounts. Occasionally, if a client is experiencing a period of very low income, it may be advisable to withdraw funds from their RRSP; especially if they have TFSA room as the tax payable on the RRSP withdrawal in a year of low income would be extremely low. In most cases, clients should first draw down from their TFSA and taxable accounts allowing the tax deferred assets to continue to grow as long as possible.

When the TFSA and the taxable accounts are depleted, then the registered account can be accessed.

Some advisors suggest that investors have a small portion of other asset classes in each account type just to prevent having to sell in a downturn if there is a need for cash.  You never know what life throws at you and repeatedly withdrawing from one account type or asset class could mean a lopsided asset allocation.

Of course there is no economic value of getting tax deferral on something that does not generate much actual return, so investing wisely is extremely important.  Smart investors can avoid the consequences associated with fragmented investment management by having their investment advisors work directly with a wealth management firm that applies an integrated investment approach including shrewd asset location. Otherwise, leaving too many cooks in charge of the pot can lead to the bad taste of unnecessary taxes.